How Should Brokers Be Compensated for Investment Research?
Most U.S. investors have not heard of the European Unions Markets in Financial Instruments Directive, referred to as MiFID or MiFID II. But the large U.S. brokers and investment banks certainly have, and they are bumping up against a July end to a “no-action” relief letter from the SEC. At issue is that the directive, which came into effect in January of 2018 in the E.U., doesn’t synch with how brokerage business is conducted in the U.S. The U.S.-based brokers have been provided time, but over five years, there is very little evidence of movement to comply.
Background
If U.S. broker-dealers (BDs) continue their business model of providing investment research to clients that is now “bundled” with other services, not charged as a separate service, they are in compliance with U.S. security regulations and don’t risk their status as a BD. However, if they follow MiFID with their international clients in order to be in compliance with Europe, they would be acting, under U.S. rules, as an Investment Advisor (the Advisers Act). This is because if they are subject to E.U. jurisdiction, under MiFID II, unless an exemption is met, research that investment managers receive from brokers is considered a prohibited “inducement.”
Research distribution in the U.S. by BDs has historically relied on a definition of “Investment Adviser” under the Advisers Act (related to research distribution). This definition looks to the condition that the investment advice is incidental to the firm’s broker-dealer business and (that the broker-dealer is not receiving “special compensation.” Hard dollar payments in exchange for investment research is considered “special compensation” for investment advice (ie., equity research). A 2017 dated SEC no-action letter and then another in July 2022 provided a window of relief from this conflict. It provided time to sort through what is allowed under different business types for those falling under both U.S. regulation and MiFID II oversight.
With fewer than three months until the SEC “no action” July 3 deadline, Wall Street firms are quiet on how and whether they may adjust their businesses. The choices would seem to be to either not provide the service of bond and equity research as part of the bundled service by acting strictly as a BD (compliance with MiFID II), or to register as an Investment Adviser that then subjects traditional U.S. brokers to additional rules and licenses.
Where We Are Now
The SEC no-action letter has allowed U.S.-based BDs to accept payments from clients where MiFID applies. This protection will soon end. If they continue the practice, they will be violating the Advisers Act, as they are not Investment Advisers.
Come July 3, they face a choice of registering, moving research teams into registered affiliates, or even cutting off clients subject to MiFID regulations from any research produced in the U.S.
In March, SEC Chair Gary Gensler and senior staff met bank representatives and industry associations to discuss the issue. But the SEC ultimately refused to alter its long-held stance, on the Advisers Act.
Take Away
Broker-dealers in the U.S. have less than three months to adjust their position on compensation methods of clients bound by MiFID II. The clock is ticking, and they are now staring down the barrel of a difficult decision. Should they transition to Investment Adviser status and charge separately for research, or should they stop providing research to affected clients altogether?
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Managing Editor, Channelchek
Sources
https://www.ft.com/content/2400b520-afa3-45ec-9767-a35805b4f98a
